European Banks Upgraded to 'Overweight': KBW

European banks still have upside potential despite the recent rally, as the worst is over for the continent's financial institutions, analysts at financial services investment bank KBW, who upgraded the European banking sector to 'Overweight', said Monday.

"Most of the negative factors affecting the sector are being removed or fading," KBW analysts wrote in a market research note.

Liquidity continues to improve, house price deflation is tapering in some markets, structured credit writedowns seem to be largely done, the threat of very dilutive capital rises is fading, while that of nationalization is largely gone, they wrote.

The European banking sector is up 101 percent from the bottom hit on March 9, and it rose 20 percent this year.

It is trading at 1.3 times net asset value, from a low of 0.6 times, but banks are still 66 percent below their peak in the first half of 2007, when they were trading at 2.5 times net asset value, according to KBW analysts.

They recommend a portfolio of 11 stocks which make up 45 percent of the sector's market capitalization.

The safer side of the KBW portfolio comprises banks with strong capital, high profitability before provisioning for writedowns and strong deposit franchises: HSBC, with a target price of 640p, Santander, with 10.2 euros ($14) target price, BNP Paribas, with 57 euros, and NBG, with 25 euros.

For attractive risk/reward payoffs, KBW recommended Unicredito, with a target price of 2.3 euros, KBC with 22 euros, Deutsche Bank with 55 euros and Credit Agricole with 13 euros.

Among mid-caps, KBW favors DnB NOR, with a target price of 56 Norwegian krone ($8.75), BPM with 6.4 euros and Mediobanca with 10.7 euros.